Proposal for how to achieve the optimal cost of capital for Arrow Wind Farms
- Cite at least four (4) peer reviewed journals APA format using in text-citations for all quoted or paraphrased material
- Minimum 3 - 4 Pgs.
- Write a proposal for how to achieve the optimal cost of capital for Arrow Wind Farms from the below information. You can make assumptions, but support your work with scholarly references.
Keep the following in mind while writing your paper.
(1) Essay should be at 3-4 pages in length.
(2) Use a minimum of four scholarly articles
(3) In-text citations and reference page must be properly formatted using APA style guidelines.
Information about Arrow Wind Farms
Dustin Hardaway is the chief financial officer of Arrow Wind Farms, which has planned to expand into several neighboring states. Hardaway wants to optimize the existing capital structure. The company currently finances its assets with 70% equity and 30% debt. Market interest rates are currently low, but expected to rise soon as the economy recovers from recession.
Arrow has a tax rate of 35%, but does not have significant profits. For its first five years of business, the company conducted business only in Iowa. During its first three years, the company ran a loss and broke even just two years ago. Only recently has Arrow started realizing small profits. With development, the company expects significant growth of about 10% a year.
Because the company's business relies mostly on equipment and not so much on people, fixed costs are high. With growth and added volume once Arrow covers fixed equipment costs, operating leverage should cause profits to rise sharply. If the volume fails to happen, the risk of loss is high.
Despite the risk, Arrow believes wind energy will grow because of the high cost of fossil fuel and rising popularity with consumers. Another reason Arrow has optimism about its growth comes from consumers' need to conserve energy and the government's push to use unconventional energy sources.
Although good cause exists for optimism, the need exists to combine alternative energy sources like wind with more conventional sources. The extent to which consumers will use wind energy is therefore uncertain. Arrow has decided it needs to look at other choices besides wind, but will not have a good idea about these projects for at least another five years.
Another issue involved in forecasting the demand and cash flows for new projects is the rapidly changing frontier for new technology. Innovation in the industry has taken place rapidly, which could change the future direction Arrow wishes to take.
Besides the changes in technology, Arrow faces uncertainty about how consumers will connect to the energy grid. Connection to the grid has major implications because consumers can sell unused energy they produce themselves to other consumers who do not have the equipment to produce their own energy. Tracking consumption and use of energy is a major issue which government has yet to settle.
Arrow will not have a clear understanding of the extent to which revenues from energy sales will rely on consumer affordability. Without any history of other revenues, projecting the net cost to consumers is difficult.
Due to the uncertainty, Arrow has to exercise caution when deciding on the mix of capital used to finance its operations. Too much debt can pose added risk the company does not want to take. Too much equity can hinder the ability to take advantage of low interest rates. Most important, no one knows how much demand how will come about and how much it will take to overcome both operating and financial leverage concerns.
The development into neighboring states will take a major investment and the company wants to keep the cost of capital low and the future cash stream high to satisfy shareholders. Because the company has a volatile history beta, estimates are shaky. Analysts have predicted beta all over the board for Arrow.
Although history has thrown beta estimates into question, the company believes it can estimate the cost of equity by adding a 4% risk premium to the cost of debt. Unstable earnings do not allow the company to use a stable growth rate to estimate cost of equity. Arrow estimated 4% risk premium by looking at other companies' cost of capital in the industry.